CHAPTER 2: COST ELEMENTS

A. MATERIAL COSTING
Part Topic Page

I Introduction to Material costing

Introduction
Relevant cost for inventory management
Factors influencing stock levels

II The inventory models

The EOQ Model
The EBQ Model
The ABC System
Illustrations

III Valuing inventory issues

Methods of pricing material issues
Preparing operating income statements
Reconciliation of operating income
Illustrations

IV Activities

Objectives
After studying this chapter you will
Know the objectives of material control
Understand the essential requirements of material control system
Appreciate the advantages of material control
Understand the distinction of centralized and decentralized purchasing
Know how to determine the various stock levels
Know how to price material issues

Introduction
The production department requires raw materials and consumable stores
for production. The purchasing department purchases these materials from
different suppliers. The storage department stores them and then issues
them ultimately to the production department. Hence there must be perfect
co-ordination between these departments to control material cost.

Objectives of material control:

The main objectives of operating material control system are:

 To avail material needed so as to reduce instance of interrupted
production.
 To ensure purchase of materials in economic quantities.
  To ensure that purchase of materials is made at the favourable price.
 To facilitate proper accounting for materials
 To ensure that the quality and specification of materials conform to the
requirements of the product
 To reduce wastage and losses of materials

Essential requirements of material control system:

 Proper co-ordination and co-operation between different departments
dealing with materials e.g. purchasing department, stores
departments, quality control departments etc
 Centralization of all purchases under the control of a competent
manager
 Classification, codification, standardization and rationalization of all
stores and computerization of operations
 All issues of materials should be made against duly authorized
requisitions
 Materials requirements should be planned properly
 Stock position should be updated continuously based available
information from the relevant departments
 An efficient system of internal audit should be introduced for checking
all material transactions

Benefits of material control

 Material control eliminates wastage in the use of raw materials
 It reduces the risk of loss due to fraud and theft
 It reduces capital investments in inventories
 It reduces cost of storage
 It ensures uninterrupted supply of materials of high quality for use in
production
 It furnishes promptly and accurately the value of materials used in
production

Centralized and decentralized purchasing

In a centralized purchasing, the task of purchasing all types of materials is
entrusted to a separate purchasing department. However in a decentralized
purchasing, each department purchases its own materials.

Advantages of centralized purchasing

 It eliminates duplication of effort and tasks
 It helps to achieve uniform purchasing policies
 It helps to reduce overall cost by securing bulk purchase for all user
units within the same organization
 It leads to specialized skill development in purchasing
 Better controls over purchasing is made possible since reckless
purchases by authorized persons is avoided
 It economizes on paperwork and accounting for purchase transactions
  Higher quality staff may be gainfully employed to handle material
control issues

Disadvantages of centralized purchasing

 The creation and running of a special purchasing department leads to
higher administration cost that small organizations cannot afford
 It may cause delays if user units are located far away over many
different places
 There may be misunderstanding between the user departments and
the purchasing department
 The initial cost of centralized purchases is very high since a separate
purchase department has to be set up

Periodic inventory system

Under this system, the stocktaking of the physical quantities of materials of
all kinds is done at a given date. In most cases it causes a lot of disruptions
to the normal operations of the organization.

Perpetual inventory system

This is a system under which inventory records are continuously adjusted
after every transaction involving issue or receipt of stock items. The records
therefore show the physical balance of inventory items at any given point in
time. Under this system any stock discrepancies must be investigated
immediately and appropriate corrections made if the records are to be relied
upon.

Setting stock levels

The following factors are considered when setting stock levels:-
i. Availability of the stock item i.e. if the stock item is readily available
in the market, then low stock levels are maintained and vice versa.
ii. Lead time /re-order period i.e. refers to the period required to
process an order and receive deliveries of the stock item. The
longer the lead time, the higher the stock level and vice versa.
iii. Stock holding cost (storage cost)-The higher the storage cost
incurred on the stock items, the lower the stock level should be
maintained and vice versa.
iv. Consumption rate- if the consumption rate is high, then high stock
levels should be maintained and vice versa.
v. Durability –highly durable stock items requires high stock levels
whereas perishable items require low stock level.

Note- Investments in stock presents a major asset for most businesses and
it’s essential that stocks should be managed efficiently.

The costs relating to stock management are classified as follows:

 i) Holding cost- this consists of the following:
a) Opportunity cost for the investment in stock i.e. what the amount
would fetch if was not tied in stock but instead invested.
b) Incremental insurance cost.
c) Warehousing and storage cost.
d) Material handling cost.
e) Obsolescence and deterioration costs.
f) Stores operations and running cost.

ii) Ordering cost- This comprises;

a. Clerical cost of preparing a purchase order.
b. Delivery costs.
c. Remuneration of purchase department personnel.
d. Clearing charges.
e. Inspection for quality costs.

ii) Purchase cost- is the amount paid to the suppliers for supplying the
stock item. It is relevant for inventory policy decisions only if there is a
provision for quantity discounts.

The Economic Order Quantity (EOQ)

This is the order size or quantity which minimizes the total relevant cost i.e.
the sum of the total ordering cost and total holding cost.

For EOQ purpose, the total relevant cost is given as:

-
Total relevant cost = total holding cost +total ordering cost

Basic assumptions of the EOQ model

i. Holding cost per unit per annum remains constant.
ii. The average balance in stock is assumed to be equal to ½ of the order
quantity.
iii. It is assumed that the annual demand is known and is constant.
iv. Replenishment of stock is assumed to be done in equal batches.
v. Ordering costs per order is fixed irrespective of the order quantity.
vi. Purchase cost per unit is assumed to be constant throughout the year.
vii. There’s no provision for quantity discount.
viii. It assumes that the lead time is known and is constant throughout the
year.
ix. It assumes that there is no safety stock

EOQ= Q= 2DCo
Ch
Total holding cost = i.e. Average stock x Holding cost per unit

Total ordering cost = i.e. No. of orders x ordering cost per order
Total cost =total holding cost + total ordering cost

TC = +

Where: D- is annual demand

Co- is cost per order
Ch- is annual holding cost (usually but not always) expressed as
a percentage of purchase price per unit.
Q –order quantity.

Illustration
A Company has an annual demand for its material amounting to 25,000 tons
Pa. The purchase price per ton for the stock item is ksh. 2,000 and the stock
holding cost is 25% of the purchase price. The ordering cost is ksh. 400 per
order.

Required:
Calculated:
a) The EOQ
b) The total holding cost
c) The total ordering cost
d) The total relevant cost

Solution

a) EOQ = = 200 tons

b) The total holding cost = = = ksh. 50,000

c) Total ordering cost = = = ksh 50,000

d) Total relevant cost = + = + = ksh. 100,000

Confirm from the above illustration that the total relevant cost would be
higher at all other order quantities e.g. (i) 100 tons (ii) 250 tons
Graphically the EOQ model can be represented as follows:-

Cost
Total relevant
cost

Total holding
cost

Total
ordering cost
EOQ
Order Quantity

Activity
The Company has an annual demand of a product amounting 60 000 units.

The price per unit is Ksh. 4,500 and the stock holding cost is % of stock
value. Delivery cost per order is ksh. 320.
Required:
Calculated:
e) The EOQ
f) The total holding cost
g) The total ordering cost
h) The total relevant cost

LIMITATIONS OF THE EOQ MODEL

1. It assumes that the purchase price per unit is constant through the year
which is unrealistic.
2. Assume that annual demand remains constant which is unrealistic.
3. It doesn’t apply in cases where there are quantity discounts.
4. It can only be operated by people having sound knowledge in stock
management.

QUANTITY DISCOUNTS
Circumstance frequently occurs where firms are able to obtain quantity
discounts for large purchase orders. Buying in large quantities to take
advantage of quantity discounts leads to the following cost savings:
 Savings in the purchase cost. This consists of the amount on the discount
itself.
 A reduction in the total ordering cost because fewer orders are made.

Note: These cost savings must however be balanced against the increased
holding cost arising from bulk stock. To determine whether or not the
discount offer is worthwhile, the benefits (cost savings) must be compared
against the additional holding cost arising from bulk purchase.

Illustration
A Company purchases raw materials from an outside supplier at a cost of
ksh.7 per unit. The total annual demand for this product is 9,000 units. The
holding cost is ksh. 4 per unit per annum and the ordering cost is ksh. 5 per
order.

A quantity discount of 3% of the purchase price is available for orders in

excess of 1,000 units.

Required
Should the Company accept the discount offer? (Show all your workings)

Solution:

D-9,000 units Discount rate = 3% = 0.03

T- Ksh. 5
H- Ksh. 4
Q =?

Price = Ksh. 7 per unit

Note: Purchase cost forms part of the total relevant cost whenever there’s a
provision for quantity discount.

EOQ= Q=

Q= = 150 units
The alternative order quantities are therefore at the EOQ and at 1,000 units.
This will result into the following costs:

Order Purchase Cost Total Ordering Total Holding Total Cost

Quantity (ksh) Cost (ksh) cost (ksh) (ksh)
(D x Price)(1-d)

150 9,000x 7=63,000 300 300 63,600

1,000 (9,000 x 7)x(100%- 45 2000 63,155
3%)=61,110
Savings(cos 1,890 255 (1,700) 445
t)

Therefore; the Company should take the discount offer because it leads to an
overall cost savings of ksh. 445.

Illustration: 2
A Company is revising its stock policy and has the following alternatives
available for the evaluation of its stock;
i) Purchase stock twice monthly of 100 units.
ii) Purchase stock monthly of 200 units
iii) Purchase stock every 3 months of 600 units
iv) Purchase stock every 6 months of 1,200 units
v) Purchase stock every 12 months of 2,400 units

It’s ascertained that the purchase price per unit is ksh. 0.80 for the whole
order where deliveries are up to 500 units. A 5% discount is offered by the
supplier on the total order for deliveries between 500-1,000 units and 10%
discount for deliveries in excess of 1,000 units. The holding cost is ksh. 0.25
per unit of average stock held per annum and the ordering cost per order is
ksh. 5.

Required
Advise the management on the optimum order quantity

Solution:
Since the purchase price is not constant, the EOQ analysis would be
inappropriate;

H- Ksh 0.25 per unit

Disc -5% for 500 -1,000 units and 10% for 1,000 units and above
D= 2,400 units
Order Total Total Purchase Total cost
quantity ordering holding cost
cost cost
100 120 12.5 1,920 2,052.5
200 60 25 1,920 2,005
600 20 75 1,824 1,919
1,200 10 150 1,728 1,888*
2,400 5 300 1,728 2,033

*The company should purchase the stock semi-annually thus implement the
10% discount policy because it’s the cheapest alternative.

Re-order level
This is the level at which an organization places an order to replenish its
stock. It depends on the lead time and the rate of demand during the lead
time.

Re-order level= Demand During Lead Time + Safety Stock i.e. ROL =
DDLT +SS
Or.
ROL= Maximum Consumption rate x maximum lead time.

Minimum stock (safety /Buffer stock)

The safety stock refers to that stock level that should be maintained to take
care of eventualities regarding lead time and usage. It is a stock allowance
meant to cover errors in forecasting the lead time and demand during the
lead time.

Minimum stock level = ROL – (Average Consumption x Average Lead Time)

Maximum Stock level

This refers to the maximum investment that should be made in stock if the
business is to make good use of its working capital.

Maximum Stock level = ROL +EOQ – (Minimum consumption x Minimum

Lead time)

Average stock level

Is the average of the minimum and maximum stock level

Average stock level=

Illustration
The Company has provided the following data in respect of its major raw
materials.

Max. Consumption 1,200 units

Ave/Normal consumption 900 units
Minimum consumption 600 units
Lead time 4-6 wks
Re-order Quantity 6,000 units

Required
i) Reorder level
ii) Max stock level
iii) Min. stock level
iv) Average stock level

(i) ROL= Max. Consumption Rate x Max. LT

= 1,200x6
= 7,200 units

(ii) Maximum stock level = 7,200- (4x600) + 6,000

= 10,800 units

(iii) Minimum stock level = ROL– (Average Consumption x Average LT)

= 7,200- (5x900)
= 7,200- 4500
= 2,700 units

(iv) Average stock level =

=2,700 + 10,800
2
= 6,750 units
Graphically, this can be represented as follows:

Max. stock
level
j

ROL

Buffer stock
ABC ANALYSIS (PARETO ANALYSIS)
Usually a firm has to maintain several types of inventory. It’s not desirable to
keep the same degree of control over all items. The firm should pay a lot of
attention to those items whose value is the highest. Therefore they should
classify them to identify which items should receive the most attention in
controlling and hence the analytical approach called ABC analysis. It tends to
measure the significance of each item in terms of its value.

High value items are termed as “A- items’ and would be under the tighest
control.
“C-items” represent relatively low value items and would be under minimal
control.
“B-items” fall between these two categories and require reasonable
attention of the management.
The following steps are involved in implementing an ABC inventory plan:
 Classify the items of inventories by determining their relative value.
 Rank them in accordance with their value; 1 st rank- “A-items’ high
value items; 2nd rank- “B-items” and 3rd rank- “C-items”.
 Compute the percentage of the number of units in each class and the
percentage of the value in each class.

PRICING AND COSTING OF MATERIAL ISSUES

When materials are issued from stores, they are valued in order to determine
the material cost of the products. The following methods are used in valuing
material issues:.
i) First in- first out (FIFO)
ii) Last in-first out (LIFO)
iii) Simple average
iv) Weighted average
v) Standard cost method
vi) Next in-first out (NIFO) or replacement cost method.
FIFO
This values materials issued on the basis of sequence/order in which they
were bought i.e. on the premise that the first items to be received are first
to be released/issued.

LIFO
This method assumes that materials issued at any time are those that are
most recently acquired. The last units to be received are the first ones to be
issued out to production or sales department.
Simple average
Simple average of prices of all consignment of stock is calculated and the
average price is used in valuing materials issued. When the first
consignment is exhausted then the price of that consignment is eliminated
from the calculation of the simple average price. Therefore in some sense,
this method follows FIFO method.

Weighted average
The total value of materials in stock is divided by number of units in stock
and the resulting figure is the weighted average price.

Standard cost method

Material issues are valued on the basis of the pre-determined standard cost
which is set by management and therefore it ignores the market price at
which stock items were acquired.

Next in first out (NIFO)

Stock issues are valued on the basis of the prevailing market prices that
would be incurred to purchase the next consignment of stock.

Specific or unit price method

Where the item issued can be identified with the relevant invoice, the actual
cost can be charged. This is usually only possible with special purpose items
bought for a particular job.

Illustration
The following transactions relate to item X15 which is regularly acquired and
stocked by general Products Kenya Limited for the month of October 2010.
The following was entered in the Company stock ledger

Oct 2010 Receipt (units) Issue (units) Unit cost (Ksh)

 4 2,800 18
6 3,300
12 2,700 21
15 2,800
18 3,100 22
19 2,800 21
22 2,250
25 2,750 22
26 3,950
27 3,200 23
28 2,600
29 3,250 24

The closing balance for September 2010 was 3,000 units received at a unit
cost of Ksh 20.

Required;
Prepare stores ledger for October using:-
i) FIFO
ii) LIFO
iii) Simple average
iv) Standard cost method (assume a standard cost of ksh. 22 per unit)
v) Weighted average
vi) NIFO

Solution
Stores ledger (FIFO-method)
Therefore the closing stock is 5,450 units worth ksh. 123,100

Stores ledger (LIFO-method)

Therefore the closing stock is 5,450 units worth ksh. 115,700

Stores ledger (Simple average-method)

Therefore the closing stock is 5,450 units worth ksh. 120,775

Stores ledger (Standard cost-method)

Therefore the closing stock is 5,450 units worth ksh. 100,400

Stores ledger (Weighted average cost-method)

Therefore the closing stock is 5,450 units worth ksh. 120,035

Stores ledger (NIFO-method)

Therefore the closing stock is 5,450 units worth ksh. 94,550

Activity
Tindo ltd buys and sells product Q-3. It values stock on the basis of last in
first out (LIFO). On 1 June 2010, stock in hand consisted of 4,500 units which
were acquired at ksh. 50 per unit. The operations for the month were as
follows:
Date Purchases Sales
June 2 5,000 @ ksh.48
4 6,000 @ ksh. 60
5 5,500 @ ksh. 49
7 4,000 @ ksh. 50
11 7,000 @ ksh. 61
12 5,000 @ ksh. 50
13 6,000 @ ksh. 47
18 7,000 @ ksh. 62
19 8,000 @ ksh. 64
20 6,000 @ksh. 49.50
21 5,000 @ ksh. 65
 22 7,000 @ ksh. 50
25 6,000 @ ksh. 49
26 2,000 @ ksh. 47
28 500 @ ksh. 60
29 14,000 @ ksh. 64

The company incurred operating cost of ksh. 450,000 during the month.

Required:
a) Prepare the stores ledger card.
b) Determine the closing stock valuation.

c) Prepare the trading account for the month.